You own a small business, and things seem to be going well.
You’ve managed to survive the first few turbulent months and have even started to grow the business a little.
What should you do next?
Common wisdom would advise that you focus on revenue and maximising sales.
You borrow, you hire more staff and take all the orders you can, anything to keep the money coming in.
That’s not the right path.
We’ll show you how sticking to this simple yet flawed strategy will lead you toward ruin.
Far from the money you think you want to come in, it’s the money going out that matters.
Revenue means nothing if you are spending more than you earn.
Profit is king, and we’ll show you how to go about securing it.
Here you’ll discover:
- why every business leader should pay themselves what they deserve;
- why you should never, ever go into debt; and
- why you should pay your staff as a winning AFL coach would.
Pay the correct market salary
Business owners or entrepreneurs should always pay themselves the correct market salary.
Here’s a surprising figure: 90% of small business owners pay themselves less than a fair market salary.
And in many ways, this is a rational choice: After all, by lowering their salary costs, business owners can make pre-tax earnings look much stronger.
But despite this, many should always pay them the correct market salary.
There could be two reasons.
Reason #1: By not paying yourself (or your staff) a market-based wage undermines your business
Pre-tax profits and labour expenses are key figures which affect substantial financial measures such as labour productivity, or the portion of pre-tax profits to revenue.
By artificially altering them could affect your ability to grow your company.
You should also know that ATO has included this tactic – that is, underpaying wages – in a list of “dirty dozen” tax frauds used by closely held corporations.
Accordingly, ATO is increasingly choosing to audit companies suspected of employing this practice.
Reason #2: Paying yourself a market-based wage is crucial when it comes to selling your business or making an exit.
That’s because your company’s profitability is a key factor in determining its fair market value.
So when an outside party looks at your books before purchasing your business, artificially lowered salaries could project doubt on your company’s value in the eyes of a potential investor.
Alternately, paying yourself a market-based wage from the outset will save your business cash flow problems (and the nasty surprise of diminished earnings) if you choose to exit and replace yourself with an external CEO who’s expecting to earn a market salary.
Focusing on healthy profits will guide your business through its critical adolescent years.
At some point, every company risks falling into a black hole.
We aren’t talking about space travel.
A black hole is when your revenue first surpasses $1 million, and there’s an increased demand for staff, but not enough capital to pay for new employees.
At this point, many business leaders will focus on balancing the budget, but that’s not sufficient.
If you want to dodge the black hole, you must aim for 10% to 15% pre-tax profitability.
In other words, getting through a black hole is like a pioneer making a road trip from Melbourne to Sydney.
Even if you stock provisions from the outset, if you deplete your resources too soon without adding more as you go (or if you incur losses but don’t build gains as you grow), you’ll never make it to Sydney!
That’s exactly why your goal should be to accrue strong earnings while you grow.
By reinvesting profits and building your capital reserves, you’ll make it through that black hole.
What’s more, the benefits of being profitable while you’re in a black hole don’t end when you get out of it.
Because if you choose to sell your business, historical profitability will have a vital impression on your company’s value.
Prospective investors will want to see your last three years of pre-tax profits and equity – a broad measure used to gauge your company’s value.
Thus, a company that has achieved 10% to 15% pre-tax profitability will have a considerably higher market value than another company with smaller profits or none.
Do you want to position your business to achieve an optimal market value? Of course!
Keep labour costs down and have a salary cap
Keep labour costs down and protect 10% of your profits by implementing a salary cap.
As we discussed in the previously, 10-15% profitability should be your company objective.
But how can you accomplish it during that black hole period, when you’ll need to hire new staff to fulfil growing demand?
Firstly you have to understand the relationship between labour expenses and profitability.
You already know that labour is a significant cost in running a business.
But unlike rent and supplies, labour is a cost you can control.
And that’s exactly why you should introduce a salary cap to protect at least 10% of your profits.
Imagine you’re earning $1 million in revenue.
In that case, you should aim for profits of at least $100k.
Simply combine all your non-labour costs and subtract them from your $900k operating budget.
Whatever is left is your firm’s total salary cap, and should include all labour costs (including your market-based wage).
But then to keep growing, use the salary cap as support to shift between 10% and 15% profitability.
Once you have a salary cap based on 10% profits, you can set your sights on growing profits to 15% by recalculating your salary cap accordingly.
Then, you should concentrate on enhancing productivity, rather than increasing revenue.
Once you’re at 15% profitability, and it’s time for you to hire new staff.
Productivity increase is essential to meet your salary cap and reach profitability.
We’ve learned that often you’ll need to focus instead on enhancing the productivity of your existing employees instead of just hiring new staff.
But what does it take to build and sustain productivity?
Start by measuring productivity at your company by using the following equation: productivity equals gross profits divided by dollars spent on labour.
(And to calculate gross profits: gross profits equal revenue minus the cost of goods sold.)
While it may seem simple, this is a powerful tool as it provides evidence for your intuition and allows you to spot and respond to negative trends quickly.
And once you’ve calculated this metric, you can start implementing new practices to enhance productivity at your company.
Start by ensuring you compensate employees appropriately.
This is important, as paying too little leads to high turnover, which is not only costly but also disruptive to the workplace and detrimental to productivity.
Overpaying is also a problem as it eats into gross profits and thus negatively affects productivity.
You might be overpaying someone if their job requires fewer skills than it did in the past, due to the emergence of new technology, for example.
So instead of overpaying or underpaying, strive to pay your employees a reasonable market-based wage.
And once you’ve calibrated your compensation structure accordingly, you can implement an evaluation system to increase productivity.
The benefits of doing so include instituting a better way to manage employee expectations; a way to highlight areas for improvement; and especially, turns your focus toward career planning.
This last point is especially beneficial for productivity, in that it encourages employees to develop their skills and stay motivated.
It will also improve employee retention, which saves time and money.
And to get the most out of employee evaluations, it helps to identify three to five skills that could improve productivity for each role.
Additionally, it’s good practice to ask each employee to describe how their role contributes to the firm’s targeted profitability level.
The four forces of cash flow
Pay attention to the four forces of cash flow: tax, debt, core capital target and distributions.
Labour costs aren’t the only thing involved in running a healthy business.
If you want to stay solvent, understanding the four forces of cash flow is crucial.
So here they are – the four forces:
Force #1: Tax
Put money aside to pay taxes. Failure to do this can create liquidity problems, even if your business is profitable.
Force #2: Debt
You run the risk of default and foreclosure when you fail to meet debt payments.
Force #3: Core Capital Target (CCT)
A buffer to cover normal fluctuations in cash flow. We’ll discuss this in further detail below.
Force #4: Distributions
Once you’ve covered the first three forces, you can safely start distributing some of the company’s profits to yourself.
This is crucial, so we’ll say it again: you shouldn’t pay distributions until you’ve built up enough cash reserves to handle the first three forces.
And this gets us back to our 10% to 15% profitability goal.
This principle is also crucial for cash-flow management, as profit reinvestment will help your business reach your CCT.
It’s important that you keep these forces in mind and follow them, as unquestionably, there are always highs and lows in the business cycle.
You will experience periods when money is tight – just think about tax time when all that cash flows out of your bank account!
The Core Capital Target (CCT) is there to cover these cyclical swings.
And you can calculate the CCT simply by reviewing your company’s history.
As a rule of thumb, it’s recommended that you build up two months of operating expenses.
For example, if your start-up deals with long waits on account receivables, the CCT might need to exceed two months of operating expenses.
As we mentioned earlier, you can invest your profits to build this buffer.
This should be a top priority before you even think about taking distributions from the company.
If you need to raise capital, it’s better to live off your savings than going into debt.
As we’ve learned, maintaining 10% to 15% profitability is the best way of raising capital.
Don’t borrow to raise money
Debt is dangerous, so it should only be your last resort.
That’s because when you borrow other people’s money, you’re more likely to take risks with it.
When you start a business with your money, in contrast, it does feel more precious; therefore you will be more cautious.
You should treat borrowed money the same way.
Remember: debt is dangerous!
This also applies to start-up capital from venture capitalists.
These people tend to be cautious investors who expect growth and a high return on investment.
And all too often, after a company’s growth plateaus, investors decide to wind up their interests and sell business assets.
But what should you do if you don’t have that much money to invest upfront?
It’s called sweat equity.
As we’ve discussed, when you’re running a business, it’s important to pay yourself a market-based wage.
But temporarily paying yourself a below-market wage is way better than taking on debt.
Just make sure you’re living on your savings and not your firm’s after-tax profits!
Let’s say your market-based wage would be $75,000 annually.
And if you don’t pay yourself a salary the first year and only pay yourself $25,000 the second year, you’ve just added $100,000 to your company’s equity.
Plus, having this kind of blood-sweat-and-tears work ethic will allow you to focus on productivity and profitability.
It’s the safest path to rapid wealth creation!
Spot trends and quickly take action
Regularly monitoring key measures will allow you to spot trends and quickly take action.
The secrets to your company’s success are already there; they’re just buried in the data.
And that’s why regularly monitoring key measures will help your business thrive.
Don’t overwhelm yourself with too many numbers.
Find just a few, ones that are essential to your company’s survival and positive development and growth.
Crucially, you have to pay attention to your cash balance every day.
Especially if you’re new, as younger companies are at risk of falling into cash deficit in the first few months.
For new companies, being vigilant about the cash balance is an existential matter.
Knowing what’s happening daily will allow you to focus on getting your bills paid.
And then on a weekly basis, you should mind three metrics: sales, labour productivity and the cash-flow forecast for the next fortnight.
This is where you need to be watching for trends.
For example, if you notice a decline in labour productivity over the course of two weeks, you can work on turning things around before any serious harm is done.
Creating a meaningful profit-and-loss (P&L) statement will also help you spot trends and give you time to make necessary adjustments.
And that’s why you should look specifically at “rolling” profit-and-loss statements.
Ordinary P&L shows revenue, costs and expenses, along with the primary performance measures like labour productivity or any salary caps.
Separately, a “rolling” P&L focuses on just the last 12 months, revealing many trends.
For example, if you aren’t meeting your 10% to 15% profitability goals, you can see what your salary cap should have been to reach the target.
Carefully monitor metrics to forecast your cash flow and identify problems before they pop up.
Once you’re in the habit of regularly monitoring key metrics and looking for trends, you can also implement forecasting to maintain your business growth dynamically.
Cash-flow forecasting might sound daunting, but it’s easy to master.
Here’s how it works:
When you take your profit-and-loss (P&L) statement, you’ll note several future key costs that you can predict with some certainty, like rent.
And you’ll see other fees, like labour, over which you have significant control.
And then, looking at your performance over the last few months, you can make solid educated guesses for things like operating expenses and projected revenue.
Since we’re forecasting cash flow, your P&L history will also reveal payments that haven’t yet come through.
This information will allow you to predict future cash flow and also spot any discrepancies.
And that gets to the power of forecasting – going back periodically and checking the accuracy of forecasts will give you insight into potential problems before they do too much damage.
To do this effectively, you have to predict all your key metrics (like labour, productivity and accounts receivable) concerning your profit target.
By working backwards from your profit goals and Core Capital Target (CCT) targets, you’ll be able to identify desirable productivity rates, labour costs and other factors.
And once you’ve done that, you can then ask yourself: Have I reached my goals?
Am I moving in a positive or negative direction?
The answer to the second question is especially crucial because it provides a warning sign if things are going south.
That way, you can check your metrics, figure out the problem and fix it.
Don’t forget that companies can’t be moved or turned on a dime!
Understanding the relationship between the various metrics buys you time and gives you the opportunity to steer your business true before you crash and burn!
The Key Takeaways
Sustaining profitability, avoiding debt and improving productivity are some of the sound business practices that can help you boost profits and raise your company’s market valuation in the longer term.
Tip: Don’t focus on revenue too much when it comes to maximising your profits.
Many business owners focus on revenue to the exclusion of all other metrics.
And although it’s tempting to do so too, remember that concentrating on the size and growth of income instead of more insightful metrics, such as profitability and productivity, can be misleading and potentially damaging to your company.
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